You’ve spent years building up your retail business, you’ve made it into a success but now you’re looking to take your foot of the accelerator and take it easy for a while. Maybe you’ve received an offer you can’t refuse from a competitor, perhaps some of your staff are interested in buying out the business or maybe your children are interested in taking over.
Before you do a deal, you will need to understand your options and the tax consequences of those options.
As you approach later life, having a life plan in mind – including a plan for what will happen to your business – is worth having, even if you are still in good health and have no immediate plans to retire. It’s not just about tax either; minimizing your exposure to tax is certainly important but there are other factors which make a succession plan valuable:
- You’ll want to minimize family discord, by making it clear what your intentions are, even if not all family members are on board with your plan
- Having a succession plan in place will give you time to “groom” a potential successor, whether from within the family or from an external source
- A well thought out plan will protect and enhance your wealth – building up your super, protecting your assets from creditors as well as itinerant family members
How might you exit your business?
The main ways in which you might look to exit your business are:
- Selling the business
- Passing the business to family members or others already within the business
- Closing it down, by ceasing trading and selling the assets
- Liquidating the business
Selling the business
In practice, the most common way to exit a business is to sell it. Before you can do that, there are some essential steps that you’ll need to take:
- Get a valuation. You’ll need a fair, impartial understanding of what your business is worth. That will help dictate the price and may also concentrate your mind on whether you want to progress with the sale or not. Later on, if you do sell and you’re working out your tax liability, a valuation done at the pre-sale stage can help in any discussions with the ATO about the values used in your CGT calculations. A valuation isn’t just about assessing the past performance of your business and the value of your business assets; a purchaser will also factor in the future prospects of the business after you’ve gone.
- Get your records up to date. Potential purchasers will want to do due diligence on your business and that means they will expect to see clean, clear, complete business records
- Understand what you’re selling. Are you selling the whole business or just part of it? Are you selling shares in a company or assets owned by the company? You’ll need to be on the same page as your potential purchasers.
- Understand how you will sell. You might need to engage a business broker to market your business or you might already be aware of a potential purchaser in your circle of contacts.
- Obtain professional advice. Take tax, accounting and legal advice throughout the process, from the initial succession plan through to the closing of the deal.
- Assess your future involvement. Some purchasers like the previous owners to stay on to provide stability for staff and customers, either as an employee or a consultant. Are you prepared to do that or would you like a clean break?
Passing on the business
For many people, the preferred option is to pass the business on to the next generation. That won’t always be an option; sometimes the next generation simply isn’t interested in taking on the business or isn’t capable enough to do so.
The tricky part of this is ensuring that the “old” generation takes away a decent return for all their hard work over the years, whilst the “new” generation isn’t crippled by debt to enable that. To ensure that all parties feel happy with the deal, often the best way to do that is for the “old” generation to simply sell the business to the “new” generation at market value, based on an independent valuation. Selling for less than market value can have CGT consequences since tax law often substitutes market value where a transaction occurs between connected parties, such as family.
Where more than one child or other relative is taking over ownership, it can be worthwhile forming a family trust structure to own and operate the business.
Closing down the business
This is an option that is rarely attractive and is generally only resorted to where the business’s future prospects are bleak, such that a buyer can’t be found or the amount a buyer would offer is less than the value of the assets of the business. If you choose to close down, you simply sell off your business assets, pay off your creditors and take out whatever is left.
Liquidating the business
Only a company can be liquidated. A liquidation generally occurs when one of the creditors of the company petitions the court to have the company liquidated. A liquidator is appointed to collect and sell the assets of the business and then distribute the funds to the creditors, with anything left over going to the owners of the company. The liquidators own fees are also paid from the assets of the company (and note that the liquidator gets top priority in getting paid out).
Realistically, a liquidation only happens when something has gone badly wrong and the company cannot pay its debts. It would not normally be an option as part of a planned exit strategy.
Tax consequences of exiting a business
The good news is that if you decide to sell your small business (or otherwise dispose of it), there are a variety of concessions available which can help you defer, reduce or even eliminate any potential capital gains tax (CGT) consequences arising on the disposal.
The 50% discount
Before we discuss the specific small business CGT concessions, it’s worth mentioning the general 50% discount available against most capital gains arising on the sale of assets, including shares, property and business assets.
The main features of the discount are as follows:
- The discount is available to individuals, trusts, partnerships and complying superannuation funds but not to companies
- The rate of the discount is 50% for individuals, trusts and partnerships and 33 1/3rd% for superannuation funds
- To qualify, the asset must have been owned for 12 months.
Clearly, qualifying for the 50% discount is easy and it provides a very valuable relief. But if you also qualify for one or more of the small business CGT concessions, you can potentially go one step further, even reducing your tax bill down to zero.
Relief for small businesses
The special small business CGT concessions are available in addition to the 50% general CGT discount.
The policy intent of the small business CGT concessions is to encourage participation in the small business sector by providing a variety of tax efficient mechanisms which reward long-term investment in a small business. They do this by reducing or in some cases totally eliminating capital gains arising where small business people exit or reduce their involvement in trading businesses or – in the case of the rollover relief – they dispose of one small business asset and replace it with another.
There are four CGT concessions that may apply on the disposal of a small business:
- The 15-year exemption
- The 50% reduction
- The retirement exemption
- Roll-over
Broadly speaking the concessions are available provided you run a small business (which for these purposes is one with a turnover of less than $2 million) and the assets being sold are active assets, which basically refers to assets which are used in a business. Shares in a company can also be active assets if the underlying business of the company is trading in nature, rather than investment driven.
The Concessions
If you pass the basic tests, above, you’re then into the small business CGT concessions regime and can consider which concessions to take advantage of.
The 15-year exemption
If you meet the basic conditions, a small business asset disposed of is totally exempt from CGT if you have owned the asset for at least 15 years up to the disposal, you are at least 55 years of age and are retiring. The exemption can also be claimed if you become permanently incapacitated, in which case you don’t need to be 55 and nor do you need to retire.
Small business retirement exemption
A taxpayer can choose this exemption to completely eliminate a gain up to a lifetime limit of $500,000. Although commonly used in a retirement situation, it isn’t actually necessary to retire to benefit from it. If you are under 55, money from the disposal of the asset must be paid into a complying superannuation fund or a retirement savings account. If you are over 55, there is no obligation to place the proceeds into super (though you can do so if you want).
A common planning strategy for those aged 53 to 54 who don’t want to pay proceeds into super is to roll their capital gain over using the small business roll-over relief (see below) and then take advantage of the retirement exemption when you hit 55.
50% active asset reduction
Where a capital gain is derived from the sale of an active asset (see the description above), a 50% reduction is available. That’s in addition to the general 50% discount, so taking the two together, the gain is reduced by 75% for entities other than companies (which can’t claim the general 50% discount, but can claim the 50% active asset reduction).
Roll-over relief
The fourth small business concession doesn’t exempt a qualifying capital gain from tax at all; it merely defers it.
This relief allows a business owner to “rollover” the capital gain derived from the sale of their business (or an asset in the business) for two years to one or more new businesses or business assets.
And finally
Although the CGT concessions can produce a surprisingly healthy tax outcome when exiting a business, the rules are very complex and it pays to take advice with a tax accountant such as H&R Block to check what you’re entitled to and to ensure that your exit is structured in such a way as to meet both your tax and broader financial and lifestyle goals.
Mark Chapman is director of tax communications at H&R Block.